NY futures sold off this week, as December dropped 546 points to close at 81.80 cents.

After moving sideways between 86 and 90 cents for four weeks, the market finally woke up last Friday. But instead of resuming its uptrend as most of us were expecting, the market fell out of bed, dropping around 700 points in just four sessions, before recovering slightly today.

While a mildly bearish WASDE report may have contributed to the weakness last Friday, the selloff was clearly tied to the drop of the Turkish Lira, which lost 13.5% against the US dollar in just one day. This in turn raised fears of a contagion in emerging markets, many of whom have already been facing financial struggles recently.

At the root of the problem is the massive amount of dollar-denominated debt in emerging markets, which has more than doubled to USD 3.7 trillion since 2009 according to the Bank for International Settlements. As interest rates rise and local currencies depreciate against the US dollar, debt service becomes harder, if not impossible, for some of these nations.

The Turkish Lira is down about 70% from a year ago and currencies of US cotton importers as well as export competitors are weakening. In the case of importers like Turkey, Indonesia or China it makes it more expensive to buy US cotton, while competitors like India (Rupee at historic low this week) or Brazil gain a competitive advantage on the export front.

The fact that the US itself needs to find buyers for around USD 1.7 trillion in treasury debt at higher interest rates in fiscal year 2018/19 makes matters worse for emerging markets, because it leads to a crowding out of available funds. It’s all a game of confidence, which the US seems to be winning at this point.

The August WASDE report showed a 19.24 million US crop, which was right in line with our estimate. We even feel that the US crop has room to grow, judging by the latest field reports from the various regions. The larger crop combined with fewer shipments in July led to an increase in US stocks, with beginning stocks now at 4.4 million bales (up 0.4 million) and ending stocks at 4.6 million bales (up 0.6 million).

While the US numbers were bearish, the global numbers were supportive in our opinion, mainly due to another increase in global mill use to a record 127.62 million bales (up 0.66 million). This has widened the global supply gap this season to 7.1 million bales, with China’s supply gap of 16.0 million bales being only partially offset by a ROW surplus of 8.9 million bales.

The question is of course “how much will China import”? At the moment the USDA has Chinese imports at only 7.0 million bales, meaning that the rest of China’s supply gap would have to be filled from internal stocks.

Since China is not expected to absorb the entire ROW supply surplus (only 7.0 out of 8.9 million), it follows that ROW stocks are going to increase slightly this season, from 46.71 to 48.46 million bales. However, we still feel that these numbers are overstated due to ‘phantom stocks’ in India and possibly China, but the trend is what counts and it currently shows slightly more ROW stocks this season.

US export sales slowed down considerably last week, as net new sales of Upland and Pima cotton amounted to just 68,800 running bales for both marketing years, while shipments were at 244,900 running bales. For the current season we now have commitments of a little over 8.8 million statistical bales, of which 0.3 million bales have so far been exported. Sales for next marketing year remain at around 1.35 million statistical bales.

So where do we go from here? From a technical point of view the market has broken through all kinds of important support levels this week, starting with the long-term uptrend line at around 8400 and then the July low of 8175. The last line in the sand is the 200-day moving average at just over 7900, which is often used as an important tool by long-term speculators. So far spec liquidation has been moderate, as open interest has only declined by about 10k to 261k, but the market needs to quickly prove itself if it wants to avert further damage.

From a fundamental point of view this turmoil in emerging markets puts the fairly optimistic mill use number of 127.62 million bales in question. The bull market that started last fall in the high 60s has been driven by stronger than expected demand and we wonder whether this engine is still firing on all cylinders? Tariff wars and sliding emerging market currencies will likely take some toll on demand and if crops continue to do well, then the global supply gap could end up being a lot less than 7.1 million bales. Combined with weaker emerging market currencies this would make it difficult for physical prices to rise.

Fortunately there are still 15.9 million in unfixed on-call sales, of which over 5.0 million are on December. This underlying support should help to absorb additional spec selling and if speculators were to stay invested, as they did during previous sell-off attempts, then we could see the market bounce back strongly. However, at this point a lot depends on how these trade conflicts play out and whether emerging markets can hold it together. Until we get more clarity on these issues, we expect the market to remain volatile, with about equal odds between a sell-off to 77 cents and a rebound to 85 cents.

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